Traditionally, China is blamed for holding its currency at an artificially low level to spur exports. If the yuan appreciates, it would be bullish for everybody but China, because there will be more exports and higher growth in Europe and the U.S. But it could also lead to higher prices on Chinese goods imported to the US, causing inflation and leading the Fed to hike interest rates sooner. China couldn’t function without massive orders from the U.S. The U.S. Treasury is counting on the Chinese to hurl money at the US, which held down interest rates.

The following USD-yuan chart () shows that $1US=8.3 yuan before 2005. Now $1US only worth $6.8 yuan

Comparison between the U.S. and EU

The euro has depreciated dramatically against the U.S. dollar over the past few months. The move has caused many investors to question the viability of the EU and its currency. George Soros called the euro patently flawed because EU members had to independently rescue their banking systems in the 2008 crash. According to the IMF, the U.S. dollar accounts for 64% of global central bank reserves, versus 26% for the euro. If China stays away from the dollar, the euro and gold could be the biggest beneficiaries.

The economies of the EU (27 countries) and euro zone (16) are similar in size to that of the U.S. The following data from Forbes shows the EU is in a better shape:

Descr

US

EU

2009 GDP Growth

-2.7%

-4.2%

2009 Inflation

2.7%

0.9%

Deficit as % of GDP

10.6%

6.9%

Gross National Debt as % of GDP

87%

84%

Gold Advanced Against All Major Currencies

Countries around the world fostered the inflation of assets prices by transferring trillions in private sector debts to the balance sheets of governments. As a result, SPDR Gold Shares (NYSEARCA:GLD) was up 28% since Jan 1, 2009. Following chart from Minyanville shows gold’s movement against other currencies ():

Commodity Currencies: AUD & CAD

Commodity companies are likely to continue their role as leaders around the globe. This will be driven by dollar woes and rising demand for commodities from emerging economies. China’s appreciated yuan could boost commodity currencies such as the Canadian and Australian dollar as well.

The following FXCM Speculative Sentiment Index (NYSE:SSI) from DailyFx shows that the ratio of long to short positions in the USDCAD stands at 3.39 as over 75% of traders are long. The SSI is a contrarian indicator and signals more USDCAD losses.

Over the last few months, CurrencyShares' Canadian Dollar Trust (NYSEARCA:FXC) has been stuck in a trading range between $93 and $97. Even though I am long the Canadian dollar, I wouldn’t increase my position at current levels.

The idea of carry-trade is to capture the interest rate spread between different currencies. An investor borrows money in a low interest rate currency, such as the dollar, yen or British pound and then invests the proceeds into higher yielding currency such as Australia (3.75%) and Brazil (8.75%). The most popular ETF which adopts this strategy is PowerShares DB G10 Currency Harvest (DBV).

Conclusion

China faces pressure to appreciate the yuan when the U.S. dollar is weak. When the dollar weakens, the yuan effectively devalues against other currencies as well. If the dollar weakens enough, China might be forced to revalue. On the other hand, the strengthening dollar means less pressure on China. Either way, it seems like a safe bet that global pressure would prevent China from allowing the yuan to depreciate any further.

Foreign-currency fluctuations are driven by factors such as interest rates, economic growth and deficits, and not just in the United States, but also in foreign countries. Also, the change in sentiment can flip quickly. Nonetheless, maintaining some long-term non U.S. dollar exposure is another way to diversify your portfolio.

As Peter Schief writes in his book, Crash Proof 2.0, China might finally pull the plug on its currency peg, allowing the dollar to go down the drain. The dollar has been losing value against other currencies in part because foreign appetite for U.S. assets is waning. As long as the trend continues, you could make money on currency ETFs which hold stronger foreign sovereign bonds paying interest.

Disclosure: Long FXC. Data are from Yahoo Finance and Sina as of March 5, 2010.